Investment column: Room to grow

Scott McEvoy | October 1, 2014

Proposed changes to the pension plan investment rules signal good news for ETFs

Increased use of exchange-traded funds (ETFs) by institutional investors is a growing trend worldwide. However, ETFs and other pooling vehicles don’t fit easily into the investment rules for Canadian registered pension plans. This article highlights the challenges of applying these rules to ETFs, as well as recently announced proposed changes.

The investment rules apply principally to the pension plan administrator. In Canada, the federal rules—specifically, Schedule III to the Pension Benefits Standards Regulations, 1985—are incorporated into most provincial pension legislation.

Schedule III prohibits the administrator from directly or indirectly investing or lending more than 10% of the book value of the plan’s assets in or to any one person, two or more associated persons, or two or more affiliated corporations. For ETF providers, two important exceptions are: segregated funds, mutual funds or pooled funds that comply with Schedule III; and funds that replicate the composition of a widely recognized index of a broad class of securities traded on a public exchange.

But there are ambiguities in applying these rules to an ETF.

For example, the prevailing practice among administrators is to treat the 10% diversification limit as an ongoing requirement rather than on a historic (time of purchase) basis. Such conservative treatment may lead to a passive breach of the restriction. Also, book value means the cost to the entity that’s acquiring the asset, including all direct costs associated with the acquisition—values that may not have been tracked and recorded.

Changes Afoot
The federal government has announced plans to change these rules. One change would be to limit investments to 10% of the market value, rather than the book value, of the pension plan assets. This change is welcome, since market values are easier to determine.

As noted earlier, it’s permissible to invest more than 10% in a fund that “replicates the composition of a widely recognized index of a broad class of securities,” but there is currently no guidance on what broad means (although we expect the index should be similarly diversified). Also, the definition of “public exchange” has not been updated in many years (e.g., the Nikkei would not qualify for the exemption because no Japanese exchanges are listed).

Under the proposed changes, “public exchange” would be replaced with “marketplace” to reflect that plan investments may be bought on public exchanges, quotation and trade-reporting systems, or other platforms on which buyers and sellers of securities and derivatives are matched.

Schedule III prohibits the plan administrator from directly or indirectly investing in the securities of a “related party” or entering into a “transaction” with a related party on behalf of the plan. (However, this is subject to certain exceptions.) Whether funds that a manager considers proprietary would be included in this prohibition will depend on their structure, as well as on the level of ownership by that manager in the manager/trustee of the particular fund. The proposed amendments would remove certain related party exemptions, such as the nominal or immaterial transaction exemptions, and permit other exemptions, such as investments in the securities of a related party if the securities are held in an investment fund.

While the timing for implementing these changes is unclear, ETF providers can look forward to favourable outcomes as a result.

Book Value vs. Market Value

❱❱ Book value is the price you paid for an asset. That price never changes for the entire period of your ownership.
❱❱ Market value is the price at which you can currently sell that asset.

Source: Investopedia

Scott McEvoy is a partner with Borden Ladner Gervais LLP for the Canadian ETF Association.